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Tuesday, November 4, 2014

November-December 2014 Outlook: The Relay

TradeTheNews.comNovember-December
2014 Outlook: The RelayThis past Sunday, New
York City hosted its annual marathon amid extremely blustery conditions that
brought recent market activity to mind. The extraordinary events of late
October reintroduced a concept that was lost on the markets for three years -
volatility. With everything but the proverbial kitchen sink thrown at
sentiment, US equity markets took a nearly ten percent dip, threatening one of
the longest bull runs without a correction in history. An existential crisis in
Iraq, sudden visions of an Ebola pandemic, and the uncertainties around the end
of the Fed's bond buying program combined to alter the trajectory of markets,
if only briefly. But to the delight of risk-on market participants, just two
days after the Fed announced the end of QE3, Japan launched a new flight of
stimulus-tipped arrows, announcing its giant public pension fund would shift to
more aggressive investment while the BOJ expanded its asset purchases. The
popular image that immediately took hold in the financial community was that of
the Fed handing off the quantitative easing baton to the BOJ (with hopes that the
ECB will run the next leg in 2015). Though it is dubious that there was any
coordination here, a smooth hand off of that baton will be needed to keep the
markets from stumbling.

Fed Finishes the First Leg

At its late October meeting the Fed followed through as promised and tapered
the last $15 billion of its monthly quantitative easing program. The QE program
was effective in buying time for the economy to heal, and its end should
probably be taken as a vote of confidence in US economy. In reality the end of
QE3 is just the equivalent of scraping the froth off the top of the stein-full
of accommodation the central bank is still providing: A four trillion dollar
balance sheet and near zero rates abide.

The withdrawal of the two dissenting votes at the October FOMC meeting
indicates that the hawks on the committee are satisfied that the end of QE3 is
the first step in the long process of unwinding accommodation that will next
move to rate tightening some time in 2015. The hawks are rooting for 'rate lift
off' in the early part of next year, while Fed Funds Futures show the markets
see it in the latter part of 2015.

Though the Fed is now looking out toward normalization on the horizon, it has
been increasingly stressing that policy decisions are strictly data dependent.
This principle was important enough that it was written into the October
monetary policy statement: "if incoming information indicates faster
progress toward the Committee's employment and inflation objectives than the
Committee now expects, then increases in the target range for the federal funds
rate are likely to occur sooner than currently anticipated. Conversely, if
progress proves slower than expected, then increases in the target range are
likely to occur later than currently anticipated." This leaves wiggle room
on both sides of the equation, but the data has been trending better since the
spring. Indeed, one development that could accelerate the liftoff schedule
would be the materialization of an as yet elusive pick-up in wage inflation.

The next leg of the race for the Fed will start at the December 17 FOMC
meeting, when it is expected to address the forward guidance statement that
says rates will stay low for a "considerable time following the end of its
asset purchase program." New language is in order to further emphasize
data dependence and to move away from any calendar-based notions about when
rate tightening will begin.

Thus the Fed is giving itself a broad timeframe for when rates might start
rising and even when it does begin, the central bank has told us that rates
will likely keep rates below normal for "some time" (a clause that
has been in the FOMC statement since March). Markets may soon start to dread
rate lift off, but it is not likely to lift far off of zero. Though the US
economy appears to be ahead of most of the developed world in the recovery
cycle, the fact that Europe and Japan have just launched new stimulus packages
and are hinting at more could keep the Fed chained to low rates for the
foreseeable future, even if a token rate hike comes next year.

In the meantime, the specter of a currency war could arise again as the BOJ and
ECB policy actions weaken their respective currencies against the dollar. Since
the BOJ surprise announcement on October 31, the USD/JPY has weakened from 108
to 114, while the euro is plumbing a 2-year low against the dollar. While the
Fed does not officially consider the currency level, the Yellen team may start
to fret about US exports if the dollar continues to surge based on the actions
of foreign central banks.

The Handoff

Interestingly the latest risk on rally is built on the premise that the end of
the Fed's QE3 has signaled other central banks to step in and do their part for
global stimulus. Seemingly on cue, Japan stepped in with another 20 trillion
yen from the BOJ and confirmed that the GPIF, the world's largest pension fund,
would significantly increase allocations to riskier assets, including nearly
doubling its holdings of foreign securities. While the GPIF announcement had
been anticipated for weeks, the new BOJ stimulus was a genuine surprise. At the
same time, press reports made it clear that PM Abe's government is working on
another 3 to 4 trillion yen spending package of its own.

All told it is an impressive effort, and the multi-trillion yen government
package may continue to be teased in the press for weeks to come, but that
said, this may be the last gasp of stimulus from Japan. The unexpected BOJ
stimulus increase was the main driver of the October 31 risk-on rally, but it
came in a tight 5 to 4 vote, indicating the policy committee is not entirely
comfortable with the plan and that there is little chance of another expansion
in the future.

The next signpost for Japan will be its preliminary Q3 GDP data on November 16.
The BOJ just cut its fiscal year GDP forecast in half to 0.5% growth, as well
as trimming its CPI outlook, acknowledging that reaching the inflation target
that is the key yardstick of Abenomics will be more difficult to achieve than
previously thought. More discouraging growth data could weigh on the impending
decision about whether to go ahead with the second stage of a consumption tax
increase in April. The IMF has urged the government to move forward with the
tax hike to maintain the credibility of its fiscal framework, but the slower
growth seen since the first bite of the tax increase this past spring will give
Tokyo much to think about. The decision is slated for December and may be
counterbalanced by the fruition of the government spending package.

With Japan seemingly extending itself to its fullest, it may not be long before
stimulus addicted markets turn their eyes to the ECB looking for more fuel. In
short succession over the summer, ECB President Draghi announced two new major
stimulative efforts - the Targeted Long Term Repo Operations (TLTRO) and an
ABS/covered bond purchase program dubbed by some as "QE light." Even
as these programs are still just getting off the ground, the ECB is feeling
definite pressure from markets to go further with a full blown QE program, but
that may be stymied by legal limitations preventing the central bank from
supporting member nations through direct sovereign bond purchases and the
objections of the euro zone's most fiscally prudent members, led by Germany. Those
who are waiting for this final and most emphatic manifestation of the 'Draghi
Put' may be disappointed, as most indications are that there will not be any
ECB QE this year (but maybe in 2015). In the meantime the ECB may tinker with
the terms of its TLTRO to improve the results at its next operation (December
11), after a disappointing take-up it is inaugural offering.

Will China Rejoin the Relay?

If Japan and Europe have breathed their last stimulus into the global economy,
accommodation junkies may still have a white knight swoop in from other
quarters. Since the single major stimulus plan it launched in the early days of
the global financial crisis, China has been content to run a series of
mini-stimulus programs to keep its growth trajectory right on the 7.5% GDP
target. But lately, hitting that target has been getting tougher amid slower
industrial growth, a cooling real estate sector, and a relentless
anti-corruption campaign that has shaken up business-as-usual.

Through the first three quarters of 2014, Chinese GDP growth is running at
7.4%, just below the official target rate, though the Q3 reading was the
slowest quarter since early 2009, suggesting the government's targeted stimulus
measures have not yielded the expected results. Officially the China Statistics
Bureau is forecasting a stronger Q4 to make up the difference and is still of
the belief that growth and inflation figures are close enough to targets that
the government can get by with merely fine tuning fiscal policy.

Some deteriorating data may militate against that belief. China's slowdown
appears to be concentrated in the real estate sector, which accounts for about
10% of GDP or 20% if you add in related industries. In the last few months,
home price appreciation has stalled for the first time in two years and the
pace of property sales has slowed markedly (year-to-date total value of
property sales are down about 9% year over year through September). Coupled
with this, fresh multi-month lows recorded in the latest manufacturing and
services PMI readings could bring the People's Bank of China back into action.
The PBoC has been relatively quiet in the last two years but if the data
continues to decay the central bank could examine a rate cut, which would be
the first such easing since mid-2012, the last time it used rate policy to
address a perceived slowdown in the rate of economic growth.

The Race Is On

The Fed is done adding stimulus, but the US political landscape may deliver
some good mojo to the markets (instead of its usual drag), at least in the
short term. The November 4 mid-term elections could put both houses of Congress
in the hands of Republicans for the first time since 2006. Given low turn-out
in non-Presidential election years and a number of close races, pundits are
giving the GOP a better than 70% chance of winning the six additional seats
they need to take control of the Senate. Initially markets would probably take
this outcome as a positive, and the generally pro-business, pro-energy agenda
of the Republicans may give a psychological boost to beleaguered energy stocks
in particular, which have been suffering of late due to the swoon in oil
prices. A Republican Congress could push through legislation on the Keystone
Pipeline, legalization of US oil exports, and a tax amnesty for companies to
repatriate overseas earnings, putting the onus on President Obama to use his
veto. No matter what happens in the election, the US will still have a divided
government for at least two more years, and the pundits will immediately move
on to analysis of the 2016 Presidential race while Mr. Obama serves out his
lame duck years.

Elsewhere in politics, Europe will face another secession vote, this time in
Spain. The rhetoric of the Catalan independence movement has been somewhat blunted
after the independence movement was scotched in the UK, but the enclave is
still forging ahead with a non-binding reference vote on independence on
November 9. A yes vote in the Catalonia referendum could revive concerns about
balkanization in Europe, an unneeded distraction for a continent already facing
difficult political and economic challenges.

A Slippery Path for Oil

In its own way, OPEC may have made a grab for the stimulus baton too. The
steady strengthening of the greenback has had an outsized impact on the
commodity markets, leaving WTI crude trading around $80/barrel and Brent crude
about $5 higher, the lowest levels since the early days of the global economic
crisis. The rapid 20% decline in oil prices is a cause for panic in some smaller
OPEC producing countries. Venezuela, fearing the price drop in the commodity
that accounts for almost all of its exports could lead to a debt default,
clamored for an emergency meeting of the cartel to address the issue, but its
call fell on deaf ears. Saudi Arabia -- the powerhouse of OPEC and the only
member with enough spare capacity to move the needle -- appears to be content
with the current situation. At least one Saudi diplomat suggested that this
might be his country's means of providing some global stimulus. Analysts say
that if the 20% drop in oil prices sticks, it would boost global consumption
and amount to more than $1 trillion in annual stimulus, which in turn would
create demand for another half million barrels per day of oil.

The Saudis could have other motives as well. Though current the current price
of oil is near Saudi Arabia's budgeted break-even point, rival producers have
higher production costs per barrel. The Saudis recently offered price discounts
to large Asian customers, indicating that they are less concerned about price
than about protecting market share from producers like Russia (which in the
face of Ukraine-related sanctions has made strides to ship more crude to East
Asia), and Iran, the Saudis religious and political rival. Weaker energy prices
have also squeezed the North American fracking industry which has boomed with
oil above $100/barrel, but now may have to reevaluate the economic viability of
some higher cost wells.

The intentions of the Saudis may be made clear at the November 27 regular
meeting of OPEC oil ministers in Vienna. An increasing number of energy
analysts are forecasting that Saudi Arabia will relent and agree to a 500
thousand to 1.5 million barrel reduction in the OPEC production ceiling, which
might send crude prices back toward the $100 mark, if not above it. The
decision may be hinted at in OPEC's Annual World Oil Outlook released on
November 6.

Iran could turn out to be another wildcard for energy markets. Negotiations
over restraining Iran's nuclear program have been grinding on, with the latest
extension in talks setting a November 24 deadline for an agreement. The chief
diplomats for both sides have maintained a cautious outlook as this date
approaches, indicating that a lot of work still needs to be done to achieve a
viable deal. A major sticking point appears to be that Tehran wants sanctions
lifted immediately while the US and its allies are proposing a gradual
withdrawal. If a deal can be struck, more Iranian oil will eventually get to
market, but failure to reach terms might lead the major powers to put more
pressure on Iran's oil customers in Asia to reduce their consumption. In
addition, Israel, which is already on a short fuse after its most serious
confrontation with Hamas in years this summer, might see failed nuclear talks
as the signal for it to take military action against nuclear sites in Iran.

Among other commodities, precious metals are also at multiyear lows. Even
amidst the geopolitical tensions in the Middle East, Ukraine, and Hong Kong
this year gold has not gained an ounce of traction. The chart of the yellow
metal is indicating a technical breakdown may be imminent, but things might be
looking up for the gold bugs as Switzerland prepares for a referendum on the
issue of its gold reserves. If the referendum passes on November 30, the Swiss
National Bank will be required to stop selling gold and to increase its gold
reserves to 20% of its assets (from the current 7.8%). This would force the
central bank to buy over 1,500 tons of gold, or sell close to half of its fiat
money reserves, or some combination of the two to boost the percentage weight
of gold on its balance sheet. Such drastic changes might imperil the 1.20
ceiling the SNB has imposed on the franc, which nearly reached parity with the
euro in mid-2011 just before the currency cap was put in place. The latest
polling shows the yes vote has a slight edge.

Far From the Last Mile

QE is not over, it is just evolving. Japan has grabbed the baton, and the BOJ
bonanza reignited the risk-on rally. Many are hoping that the ECB will take up
QE next, but don't count on it in the near term. However, more stimulus could
come from other quarters, ranging from the US Senate to the Saudi oil princes,
or China may even pick up the baton again. In all it may be enough to propel a
melt up of risk assets into the New Year (though the jury is still l out on
whether QE has been as beneficial for Main Street as it has been for the
markets).

So what could go wrong? The doomsayers assert that we are bound for a situation
where QE becomes a permanent fixture or that all this stimulus is really just
'pushing on a string' and will eventually lead to a calamity that will eclipse
the worst days of 2008. The strong dollar trend looks ready to continue, but if
it goes too far too fast, it could erode the gains made in the US economic
recovery, and further compress oil prices. More importantly, if the ECB and BOJ
extraordinary measures don't turn things around soon, it could set up a global
deflationary spiral.

Even if the outcomes are not that extreme, the recent bout of market volatility
showed things can move quickly, illustrated by disturbingly rapid whoosh lower
seen in government bonds and oil. Markets may get unsettled again by a
resurgence of the issues that caused the October gyrations. As 2015 creeps
closer, thoughts will turn to Fed tightening, especially if improving
employment data is met with wage inflation. The geopolitical upsets in Ukraine
and Iraq are not fully resolved either, not to mention that the impending flu
season will send every hypochondriac in the western world to the hospital
screaming Ebola.

In this holiday season, here's to your health, and to hoping the central banks
execute a smooth handoff of that baton for at least few more laps.